Why Buffett Is Selling - Lehman But Insurance
Building up a war chest to serve as lender of 2nd last resort When Apollo Falls
Why is Warren Buffett selling today? Maybe he sees something brewing in Insurance markets, through GEICO.
I am in complete disbelief over the parallels that exist in today’s financial markets vs. the 2008 subprime mortgage crisis.
I recently came across the following excellent article by Lewis Enterprises. In it, he discusses the precarious conditions which exists in today’s Insurance markets, and links to another article which provides more granular detail. The gist of it is that Insurance markets today are set up with the same contagion risk that blew up the 2008 subprime mortgage crisis.
If you’ll recall from The Big Short, the subprime mortgage crisis was fundamentally a problem of contagion risk. It started with some bad actors lumping low-quality MBS into the AAA-rated tranche of CDOs, which had waterfall payments where defaults hit the equity tranches first. This supposed diversification lulled global PMs who didn’t read 2,800 page CDO prospectuses in their entirety (unlike some weirdo) into a false sense of security, encouraging them to lever up their credit exposure to the gills with synthetic CDS-squared.
Couple this with capitalistic incentives sitting across the entire value chain — from real estate agents, to originators, to rating agencies, to investment banks, to pension fund PMs — and you get yourself a ‘Too Big To Fail’ situation, where the central bank has to step in at the 11th hour to fulfill its role as lender of last resort.
If all this is going over your head, Burry not — for all you need to know is that this is the 2008 subprime mortgage crisis all over again. The only difference this time is that it’s happening in a different sector — rather than banks, it’s now in the Insurance sector.
They say generals always fight the last war — well they’d better wake up to this one, because it’s not Tier 1 Equity Capital that needs saving anymore.
Lehman Had Another Brother... His Name Is Apollo
One big question that’s been hanging over everyone’s heads is, why has Buffett been selling hand over fist recently? What could he be seeing? Everyone points to the overextended Buffett indicator (Market cap/GDP)… but it’s been overextended for awhile already, now sitting at nearly 2x GDP.
However, one thing which Buffett does have a unique window into through Berkshire’s ownership of GEICO is the current state of Insurance markets. And things are looking remarkably similar there to the Lehman situation.
Our story begins with a long-forgotten skeleton in the closet of the Lehman Brothers… they actually had a hidden brother. And while everyone was preoccupied with the sins of the former, this one adapted the tools of his trade for a different industry… which is finally coming to light, nearly two decades later.
In case the title hadn’t given it away yet, this secret Lehman orphan goes by the name of Apollo. Yes, that Apollo, one of the largest private credit firms in the world. Apollo is the brainchild of founder and CEO Marc Rowan — widely considered to be one of the brightest minds in finance and standing shoulder-to-shoulder with Jamie Dimon of JPM, Stephen Schwarzman of Blackstone, Larry Fink of Blackrock and Ken Griffin of Citadel.
This article titled Trading Complexity for Capital Intensity lays out the pure, distilled innovation which Rowan introduced to the private credit industry — by roping in the insurance business model of investing Other People’s Money.
The chart above lays out the mindboggling complexity of the financial engineering behind Apollo’s private credit empire. If you’re not interested in reading the borderline legalese explaining it in the original article, here’s an oversimplified recap of what Apollo is doing:
Many insurance companies offer annuity products, which delivers a guaranteed stream of fixed payments to the buyer over time, e.g. until death. This is effectively debt capital, since insurance companies must repay the periodic obligations of the annuity, thus representing leverage.
Apollo’s original business model of private credit is itself effectively a form of leverage, since it levers up GP returns in a risk-free manner by investing LP funds — i.e. Other People’s Money.
By pairing private credit with an insurance subsidiary, the LP funds can serve as the “first loss” equity tranche of the insurance portfolio. This juices up the reserves guaranteeing the liability/annuity book, thus enabling greater credit leverage to be assumed. The industry calls this sidecar equity, which promises higher returns given the greater risk involved (déjà vu?). This effectively represents leveraged debt squared.
The sidecar equity itself can also be levered up 10x using traditional leverage. Since it represents the equity sleeve of the insurance portfolio, it can be invested in high-risk assets like equities, thus simulating a typical fee + carry model. This should also inflate the liability tranches supporting the annuity book, representing leveraged debt cubed.
The boosted liability tranches can also participate in warehouse lending, e.g. lending to a bank which originates mortgages. It can thus participate in not just fixed income returns, but also lending-related fees — Bill Hwang’s total return swaps would be a good example of collateralized lending in supposedly low-risk assets. This introduces contagion risk.
The incestuous cycle is completed when such liability tranches are reinvested into other private credit funds paired with insurance businesses similar to Apollo — enabling technically infinite leverage as an industry-wide concern.
If you’ve been paying attention, every stage of Apollo’s specialized finance vehicle involves an ever-increasing degree of leverage. Starting with the already-levered debt capital of private credit, Apollo uses it to further lever the reserves behind the insurance company’s annuity book — which is subsequently levered to simulate hedge fund returns with a fee + carry model, whereas the liability tranches can also be lent out to others in the financial sector.
Does this not invoke stark nostalgia of 2008? I am almost brimming with tears at the resemblance. Recall how the subprime mortgage crisis started:
lenders originated low-quality mortgages, lulling investors into a false sense of security;
these were securitized into AAA-rated MBS on account of diversification;
which were repackaged into CDO tranches, thus modularizing the risk further through the waterfall payment structure;
whereupon the purported low-risk adjusted returns could be levered with CDO derivatives;
whereupon derivatives of these derivatives (synthetic CDO/CDS) could be created, enabling practically infinite leverage until it begets systemic risk.
The lynchpin of the entire house of cards in 2008 rested on two weak points: 1) the original bad mortgages, and 2) the herd mentality of crowding into popular trades. As the sushi-eating PM in The Big Short explained, everybody wanted a piece of it — it was hot garbage, but nobody knew that until the tide went out. But once the rug got pulled beneath the lower supporting structures of financial engineering, everything on top toppled over.
Apollo’s version of repackaging private credit with the insurance business above resembles the aforementioned description to a T. Recall that annuities are effectively debt capital — you borrow money upfront with an expectation to pay it back over time plus interest, and invest that debt capital to service guaranteed periodic repayments. That’s debt, no way around it.
The problem arises when the equity sleeve (i.e. sidecar capital) supporting the reserves which guarantees the annuity book is actually liquid LP funding. If sidecar capital is reduced, insurance ALM regulations require that the liability/annuity book also be reduced. And if MTM losses are involved (e.g. in a recession), the LP portfolio representing the “first loss” equity sleeve takes a massive levered hit — which may prompt redemptions.
Don’t forget that in the worst-case scenario, the equity sleeve itself is also levered 10x and invested in equities to simulate a fee + carry model. You can see how such negative outflows can rapidly feed upon themselves in a pro-cyclical environment — and in the absence of a like reduction in the liability/annuity book, may result in the same “bank run” scenario which cratered both Bear Stearns and Lehman.
But wait there’s more. Such liability tranches can also be invested in supposedly “low-risk” warehouse lending — which may not be as low-risk as they appear on paper (as the Archegos saga revealed), especially in pro-cyclical environments. Furthermore, the same liability tranches can also be invested into other private credit funds, enabling the same kind of infinite leverage trick that synthetic CDOs enabled in 2008.
It’s 2008 All Over Again
Think about the utter disaster that would befall mankind credit markets if everyone in private credit started going bust at the same time. It’d be like LTCM squared, with the Fed scrambling in its role as lender of last resort and moral persuader of Big Banks all but confessing to Too Big To Fail being entrenched into the financial sector’s business model.
I can’t speak for whether such a development will necessarily take down the entire insurance industry as well, but if so it might explain why GEICO as a reinsurer might be liquidating hand over fist — in anticipation of such a meltdown. Even the reinsurance industry would be at a loss (pun intended) if the entire insurance industry imploded all at once.
As if recognizing the apprehension of his readers, the author wraps up by claiming that The Invisible Hand should naturally bring the vices of capitalism to heel by mitigating excess supply in the form of lower returns, which should provide sufficient incentives to avoid systemic risk. Without meaning any criticism… are you kidding me lol? We’ve seen this story play out before, and only Powell knows how many digital zeros he has spilled into the real economy to negate any such fantasies. Sector rotation out of the excessively top-heavy Mag 7 (i.e. low yields for longer) into “infrastructure/AI” private credit opportunities alone will be sufficient to keep this train running… until it all comes crashing down.
And with a Fed put on the cards in anticipation of another “Too Big To Fail” situation, all the ingredients for moral hazard are already mise en place. By the way, don’t take my word for it — Apollo’s own CEO has gone on record to support this narrative. In the interview linked below, Rowan makes two claims:
Most of their success over the past decade is attributable to a lower-for-longer interest rate environment (i.e. “right place at right time); and
An admission that they are facing challenges today finding attractive opportunities to allocate capital, thus pushing the Infrastructure/AI narrative — with most of us already familiar with expected sector returns.
If I can see all this, Buffett most definitely can too. With the wealth of experience gained behind his Gen Re and AIG near-debacles, he is probably building up a war chest to mimic (support?) the Fed as lender of last resort when titanfall commences — and make a tidy mint in the process, of course.
This might also explain why the Fed has been taking such a cautious stance with regards to setting expectations in financial markets — if things start unravelling, they’re going to hell in a handbasket at warp speed. Heaven forbid that US credit markets experience a similar crash to the one that unravelled under Liz Truss — which also happened due to contagion risk in the financial sector.
I don’t know about you, but I think Kevin Spacey would be a great pick for the upcoming 2027 sequel to The Big Short.
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This is so crazy complex. As a lay person I had to look up each acronym and term. I had to do the same thing as well in 2008 while trying to understand what went wrong. Your point about how Buffett has info we don't regarding the insurance industry makes sense to me. If I recall correctly, he got out of anything derivative related well before 2008 blew up. Seems reasonable to follow his lead in this instance as well.
I can give a much simpler account of where the next financial crash will be: https://backseatpolicycritic.substack.com/p/ai-is-a-scam